Executive summary: Drastic changes to FTC for 2022
Over the course of this past year, Treasury and the IRS have released final 2022 regulations (T.D. 9959), a set of technical corrections (2022-15867 and 2022-15868) and proposed 2022 regulations (REG-112096-22) all aimed at addressing the creditability of foreign income taxes for purposes of the foreign tax credit (FTC). In general, these new rules revised the net gain requirement, ensuring that a foreign tax is only a creditable net income tax if the determination of the foreign tax base conforms in essential respects to the determination of taxable income under the Internal Revenue Code. This effectively shifts the definition of a creditable tax from an income tax (i.e., a tax on income) to being a tax that is sufficiently similar to the Code. Under these new rules, a foreign tax will only satisfy the net gain requirement if the tax satisfies four sub requirements: realization, gross receipts, cost recovery (i.e., formerly the net income requirement), plus a new attribution requirement.
The 2022 final regulations further stipulate that determining whether a foreign tax satisfies each component of the net gain requirement is generally based on the terms of the foreign tax law governing the computation of the tax base rather than empirical analysis. Also, the 2022 final regulations maintain the long-standing all-or-nothing rule. A foreign tax either is or is not a foreign income tax, in its entirety, for all persons subject to the foreign tax.
In a nutshell, historically creditable taxes may no longer be creditable for tax years beginning on or after Dec. 28, 2021 (i.e., 2022 calendar year taxpayers). Note that while certain foreign income taxes may no longer be creditable, non-creditable taxes are generally still deductible as general business expenses.
As taxpayers begin to plan for their 2022 tax provisions, they will need to consider how these changes impact their FTC, global intangible low-taxed income (GILTI) computations and other related aspects of their federal tax provision. Looking to the upcoming compliance season and beyond, it's also important to be cognizant of certain filing deadlines and understand how recent FTC guidance will impact their filing situation. Failure to plan ahead and apply the changing law could result in penalties, tax inefficiencies and lost opportunities. Here are ten important reminders for year-end planning.
Ten quick reminders for FTC
1. Section 174 research and experimental expenditures
As the 2022 tax year-end has come and gone, taxpayers closely monitoring Capitol Hill in hopes of a fix to the impending changes coming to section 174 will be devastatingly disappointed. The now in-force changes result from a delayed provision under TCJA, effective beginning with tax years beginning after Dec. 31, 2021 (i.e., 2022 calendar year taxpayers), which requires mandatory capitalization and amortization of costs incurred under section 174.
Prior to Dec. 31, 2021, research and experimental (R&E) expenditures under section 174 (R&E expenditures) were by default deducted as incurred. As such, taxpayers following that treatment did not typically track and categorize R&E expenses based on the Code’s definition of such costs. Going forward, taxpayers will need to identify the R&E expenditures not only of their U.S. companies, but of their foreign subsidiaries as well, in order to comply with the capitalization requirement. Foreign R&E expenditures must be capitalized and recovered over 15 years, while domestic costs may be recovered over five years. A half year convention applies in year one.
From an FTC perspective, this change is relevant when calculating foreign source income (FSI). Based on the concept that R&E is an inherently speculative activity that may contribute to unexpected benefits, taxpayers are required to allocate and apportion section 174 R&E expenditures against FSI. Going forward, this new capitalization requirement could be quite beneficial to taxpayers, in the context of a taxpayer's ability to claim an FTC. Taxpayers will only be required to allocate and apportion a fraction (i.e., one-fifth or one-fifteenth) of the section 174 R&E expenditures incurred, which, in theory, will lead to increased FSI. Note that section 174 R&E expenditures differ from section 41 R&E (e.g., R&E expenditures eligible for the R&E credit).
As a final reminder, the 2020 final regulations (T.D. 9922) confirm gross intangible income excludes dividends and amounts included in income under sections 951 (i.e., subpart F), 951A (i.e., GILTI) and 1293. R&E expenditures should not be allocated against the GILTI basket. The theory being that controlled foreign corporation's (CFC's) are obligated to pay arm’s length royalties for the use of the U.S. parent’s intangibles, and any net GILTI generated by a CFC after paying for the intangibles does not arise from the parent’s R&E.
2. Section 163(j) interest
Similar to section 174, taxpayers will be disappointed to hear that there has been no fix implemented before year-end to the impending changes coming to section 163(j). Another delayed provision under TCJA, these changes apply to tax years beginning after Dec. 31, 2021 (i.e., 2022 calendar year taxpayers).
Beginning Jan. 1, 2022, depreciation, amortization and depletion may no longer be added back to a company's adjusted taxable income (ATI) calculation. ATI, which closely mimicked EBITDA (earnings before interest, taxes, depreciation and amortization), will now more closely resemble EBIT (earnings before interest and taxes). This update could significantly impact a taxpayer's ability to deduct interest expense beginning after Dec. 31, 2021. The application of section 163(j) is once again relevant when calculating FSI. Based on the concept that interest is fungible, taxpayers are required to allocate and apportion interest expense against FSI. The allocation of interest expense is after the application of section 163(j). In theory, the less interest expense deducted by a U.S. taxpayer, the higher FSI will be.
3. Global intangible low-taxed income & high-tax exception
The technical corrections to the 2022 final regulations have officially closed a potential loophole with respect to the section 901(m) haircut. The technical corrections amend the GILTI high-tax exception (HTE) regulations to now refer to "eligible current year taxes" as opposed to "current year taxes" when determining foreign income taxes paid or accrued with respect to a tentative tested income item. This seemingly small revision ensures that when computing the effective tax rate (ETR) for purposes of the GILTI HTE, only creditable foreign income taxes, not those for which an FTC is unavailable, are taken into consideration. Eligible current year taxes exclude taxes for which a credit is disallowed at the level of a CFC (e.g., under sections 245A(d) or 901(j), (k), (l) or (m). In other words, taxpayers must compute the ETR after applying the section 901(m) haircut to their foreign income tax.
The delayed TCJA provisions mentioned above, section 174 R&E and section 163(j) interest, will likely impact a taxpayer's GILTI inclusion through increased tested income and an altered ability to claim the HTE. From an FTC perspective, taxpayers are likely to encounter increased FSI, which will have a direct impact on their ability to claim an FTC.
Lastly, under the 2022 final regulations, historically creditable taxes may no longer be creditable for tax years beginning on or after Dec. 28, 2021 (i.e., 2022 calendar year taxpayers). Note that while certain foreign income taxes may no longer be creditable, non-creditable taxes are still deductible for tested income purposes. In terms of GILTI, these changes could have a drastic impact on a taxpayer's ability to claim the HTE and / or FTC.
Taxpayers looking for additional information on GILTI can view RSM's previous tax alerts (Ten quick year-end reminders for GILTI)
4. Expiring credits and the statute of limitations
In general, the statute of limitations (SOL) for claiming a credit or a refund is either three years from the date the return is filed, or two years from the date the tax was paid, whichever is later. However, there is a special rule when it comes to refund claims related to the FTC. According to the courts, if the credit or refund relates to an overpayment attributable to foreign taxes paid for which a credit is allowed, the SOL period is extended to 10 years from the due date of the return for the tax year the foreign taxes were paid (Trusted Media Brands, Inc., No. 17-3733-cv (2d Cir. 8/10/18)). In other words, a taxpayer has 10 years to switch from a deduction to a credit. The reverse switch, credit to a deduction, is only allowed within the normal SOL (i.e., the special 10-year rule does not apply).
Taxpayers with expiring credits (i.e., those exceeding the 10-year carryover period) will want to analyze whether they should amend to take the deduction before the SOL expires. Taxpayers most at risk with expiring credits are those in a net operating loss (NOL) position. Calendar year-end taxpayers that extended their tax returns typically have until Oct. 16, 2023, to amend their 2019 tax returns.
Taxpayers looking for additional information on the SOL can view RSM's previous tax alerts (10-year refund statute applies only to foreign tax credits).
5. Contested taxes
The 2022 final regulations provide new rules in determining whether a taxpayer may claim a credit for contested taxes paid. In general, contested income taxes (i.e., taxes owed to a foreign government which a taxpayer disputes) do not accrue and cannot be claimed as a credit until the contest is resolved (i.e., when the liability is finally determined) even if the tax is remitted to the foreign country. However, the 2022 final regulations now allow taxpayers to claim a provisional credit (but not a deduction) for the portion of taxes already remitted to the foreign government, if the taxpayer agrees to notify the IRS when the contest concludes and agrees not to assert the SOL as a defense to assessment of U.S. tax if the IRS determines that the taxpayer failed to take appropriate steps to secure a refund of the foreign tax. Doing so alleviates taxpayer cash flow restraints that could result from temporary double taxation during the period of dispute resolution and at the same time, provides the IRS with appropriate information to ensure proper action is taken regarding dispute resolution.
It's important to note that once the contest is resolved and the foreign income tax liability is determined and paid, the tax liability accrues in the year in which the taxes relate (i.e., the relation-back year). The taxes do not accrue in the year the contest is resolved.
To claim a provisional credit, the taxpayer must file Form 1116, FTC (Individual, Estate or Trust), or Form 1118, FTC - Corporations, for the year in which the tax relates (i.e., elect under section 901 to claim the credit, instead of the deduction) and a provisional FTC agreement.
The IRS recently released new Form 7204, Consent To Extend the Time To Assess Tax Related to Contested Foreign Income Taxes—Provisional Foreign Tax Credit Agreement, to comply with these regulations. At this time, instructions to this required filing have not yet been released.
Taxpayers looking for additional information on Form 7204 can view RSM's previous tax alerts (Tax year 2022 brings more changes to international tax reporting).
6. Refundable credits
Many taxpayers may be surprised by the 2022 final regulations and how the new guidance will severely limit their ability to claim an FTC for foreign taxes that are reduced by refundable local-country credits (e.g., R&E).
Historically, the regulations provided that a payment to a foreign country was not treated as an amount of tax paid to the extent that it was reasonably certain that the amount would be refunded, credited, rebated, abated or forgiven. Further, it is not reasonably certain that an amount would be refunded, credited, rebated, abated or forgiven if the amount was not greater than a reasonable approximation of the final tax liability to the foreign country. In the context of refundable local-country credits and multiple levies, this language is unclear and often lead to uncertainty and inconsistency in application.
Treasury and the IRS address this uncertainty in the 2022 final regulations in a single, clear-cut, rule. A taxpayer can no longer claim a FTC for foreign taxes that are reduced by a refundable local-country tax credit if the local law requires the credit first reduce the taxpayer's local-country tax liability prior to refund. The exception to this new rule is where the local country tax credit is fully refundable in cash at the option of the taxpayer.
Taxpayers that receive local-country tax credit incentives will want to analyze the impact of this new rule with respect to claiming a U.S. FTC.
7. Distributions of previously taxed earnings and profits and creditability
Typically, a FTC can only be claimed to the extent a taxpayer has FSI. Thus, taxpayers are faced with a unique issue in the context of CFC previously taxed earnings and profits (PTEP) distributions in their ability to claim a credit on foreign taxes withheld associated with such a distribution (i.e., PTEP distributions do not generate FSI). Section 960(c) provides a special rule in this scenario.
In the year of receipt of PTEP, section 960(c) allows for an increase in the FTC limitation, to the extent certain conditions are met. The amount of increase is limited to the lessor of:
- The amount of foreign taxes paid on the distribution, or
- The amount in the taxpayer's 'excess limitation account' as of the beginning of the taxable year.
Note that the annual maintenance of the excess limitation account, along with the rules surrounding the ability to claim a limitation increase, are complex and require rigorous analysis. Taxpayers that have or are looking to receive a dividend distribution from their CFC(s) will want to consider the ability to claim an increase in limitation for FTC purposes.
As a final reminder, Treasury is planning to issue further PTEP guidance in the form of regulations within the first half of 2023.
8. Royalties and the single country exception
The 2022 proposed regulations provide a new, and narrow, exception (the single-country exception), to the source-based attribution requirement where a taxpayer can substantiate that a withholding tax is imposed on royalties received in exchange for the right to use intellectual property (IP) solely within the territory of the taxing jurisdiction. To qualify for this limited exception, a taxpayer must have proper documentation in place in the form of a written license agreement. The single-country exception applies where:
- The income subject to the tested foreign tax is characterized as gross royalty income, and
- The payment giving rise to such income is made pursuant to a single-country license.
A payment will not be treated as made pursuant to the single-country license if the taxpayer knows, or has reason to know, that the required agreement misstates the territory in which the IP is used or overstates the amount of the royalty with respect to the part of the territory of the license that is solely within the foreign country imposing the tax. This agreement must be executed no later than the date on which the royalty is paid. There is a special transitory rule in place for royalties paid on or before May 17, 2023. Further, the agreement must be maintained by the taxpayer and provided to the IRS within 30 days of a request by the Commissioner, absent an exception.
Of importance, the single-country exception does not apply to services, sales of copyrighted articles or instances in which the IP is licensed outside the foreign country imposing tax.
Prior to May 17, 2023, taxpayers subject to royalty withholding will want to analyze executing the single-country exception. Questions worth considering prior to execution include:
- How does the local country source royalties? Under the new FTC rules, royalties, absent an in-force income tax treaty, must be sourced based on place of use, or right to use, the IP to be creditable.
- Whether the payment is in fact classified as a royalty under both U.S. and local law?
- Is there already documentation in place with respect to the royalty agreement? Does the existing documentation satisfy the new terms and conditions to qualify for the single-country exception or is a new agreement required?
- Who is the licensee? Is the license with a related party or third party? If with a third-party, will they want to re-negotiate the terms? If with a related party, is the transfer pricing policy up to par?
- Where is the IP license physically being used? Which country or countries?
- Have there been any payments subject to withholding made to date?
9. Accounting methods
Both U.S. taxable income and foreign tested income can have an impact on a taxpayer’s ability to utilize both a current year FTC as well as a carryforward FTC from prior years. In addition, as mentioned above, the changes to section 174 R&E and section 163(j) interest expense limitations are likely to increase FSI, which will have a direct impact on a taxpayer’s ability to claim an FTC.
Proactive planning with respect to accounting methods, both for domestic entities trying to utilize an FTC, as well as CFCs, can influence both U.S. taxable income as well as CFC tested income to increase utilization of FTCs.
An accounting methods review involves the identification of one or more specific technical accounting areas where the U.S. shareholder or CFC may be applying an improper or unfavorable method of accounting, the related research into permissible methods, and the selection/implementation of the ideal accounting method given the facts, circumstances and tax strategy of the CFC and U.S. shareholders.
U.S. accounting rulemakers are planning to issue a proposal early next year calling on companies to provide detailed breakdowns about the federal, state and foreign income taxes they pay. This proposal is in direct response to long-running complaints from those using financials (e.g., investors and analysts) that disclosures provide little insight into tax exposure. While U.S. companies are required to provide total cash taxes they pay on their financials, they are not required to give a country or state breakdown. The proposed disclosures will include a requirement that companies disclose in annual reports the income taxes paid disaggregated by individual jurisdictions based on a threshold of 5% of the total income taxes paid. The proposal will also require that public companies provide additional information in the rate reconciliation regarding foreign tax effects and the effects of cross-border tax laws.
Taxpayers looking for additional information on the 2022 final FTC regulations and 2022 proposed FTC regulations can view RSM's previous tax alerts (Treasury releases technical corrections to final FTC regulations and Treasury releases much anticipated proposed FTC regulations). These alerts provide detailed insights on how taxpayers can satisfy the revamped cost recovery requirement, along with the new attribution requirement, which are two key steps in determining whether a foreign income tax is creditable under the new framework.